In calculating its risk-adjusted return on capital, your bank uses a capital charge of 2.50% for revolving credit facilities with a loan equivalent factor of 0.35 assigned to the undrawn portion. Recently, you have become concerned that the protective covenants embedded in these loans are weak and may not prevent customers from drawing on the facilities during times of stress. As such, you have recommended doubling the loan equivalent factor of 0.70. This recommendation has met with resistance from the loan origination team, and senior management has asked you to quantify the impact of your recommendation. For a typical facility that has an original principal of USD 1 billion and is 30% drawn, how much additional economic capital would have to be allocated if you increase the loan equivalent factor from 0.35 to 0.70?
- USD 3.50 million
- USD 6.13 million
- USD 8.75 million
- USD 13.63 million
The required economic capital to support a loan in the RAROC model can be calculated using the following formula:
where LEF represents the loan equivalent factor and CF represents the capital factor.
Therefore, the initial required economic capital is calculated as follows:
[(1 billion×0.3) + (1 billion×0.7×0.35)]×0.025 = 0.0136 billion
And the required capital if the change is implemented would be:
[(1 billion×0.3) + (1 billion×0.7×0.7)]×0.025 = 0.0198 billion
Hence the additional required economic capital would be 19.75 – 13.625 = 6.13 million.